Key to Procter & Gamble Co.'s pending $57 billion acquisition of Gillette Co. are the $14 billion to $16 billion in cost savings the consumer products giant expects to wring from the combination. While those projected synergies have multiple sources, a significant one is the expectation that P&G can bring its sourcing skills - honed through several major outsourcing transactions - to bear on Gillette. How significant? Well, check out the "forward-looking statements" in the five-page Jan. 28 announcement of the deal. Among the risk factors listed: "the ability to successfully implement, achieve and sustain cost improvement plans ... including the success of the company's outsourcing projects."
Mergers are risky, and so is outsourcing. It is common for both to go awry. So what do acquiring or merging companies do when faced with IT outsourcing agreements that were in place before the deal? Deciding whether to cut short or expand the existing outsourcing contract usually takes the active involvement of the chief information officer in tandem with senior management both during due diligence and once the deal is made public. If a substantial outsourcing contract is at issue, sorting through the financial implications of every scenario must be done sooner rather than later, since the outsourcing arrangements often figure prominently in the synergy calculations so central to most big deals.
Complicating the issue is the strategic dimension that many IT-based functions have. Thus, with the 2004 merger of J.P. Morgan Chase & Co. and Bank One Corp., the merged firm decided early on to cancel J.P. Morgan's $5 billion IT outsourcing agreement with IBM Corp. Under Bank One CEO Jamie Dimon - slated to go on to run the combined company - the "target" company had long since embraced the view that IT is a core competency and therefore not to be outsourced. The merged management team elected to adopt that view.
"Bank One has been very good at cutting down and consolidating their systems. It had just invested hundreds of millions of dollars in a new data center. That changed the business need for IT outsourcing services," says Virginia Garcia, senior analyst of financial services strategies, for the Tower Group Inc., an analyst firm in Needham, Mass.
Most outsourcing contracts, of course, are written to account for changes in business ownership. The typical contract would include a provision to terminate the agreement for a penalty fee (in the case of J.P. Morgan-Bank One, reportedly running into the hundreds of millions of dollars). "When there is a change in corporate ownership, there is an opportunity to exit the relationship," says Jack Benton, vice president of marketing for Technology Partners Inc., a Woodlands, Texas outsourcing consultancy. "Whether they continue with the outsourcer or not will depend on how well that arrangement meshes with the objectives of the new organization."
As CIO at FleetBoston Financial Corp. from 1999 to 2001, Dennis Rygwalski presided over a dozen major mergers and acquisitions, including Fleet's 2001 purchase of New Jersey's Summit Bancorp. Fleet traditionally used outsourcing only sparingly, for credit-card, trust and brokerage processing. Reflecting a culture that valued insourcing, all the IT infrastructure and operations were maintained in-house during Rygwalski's tenure.
In Rygwalski's experience, after a brief but intense (and secret) due diligence period, senior management would come to an initial decision about what would happen with any existing outsourcing contract. With the acquisition announcement made public, the real work of the evaluation would then begin. The Fleet CEO asked Rygwalski to analyze what-if scenarios, comb through contracts and examine fine print, and also participate in high-level discussions about strategy and alignment.
"You would have a fairly good idea of what the decision would be [during due diligence]. But after the announcement, you would really roll up your sleeves and dig down into the business needs and requirements and the strategy going forward," says Rygwal- ski, now general manager of finance industry solutions for Exigen Group, a San Francisco-based business process management software company.
The team would examine everything from who the provider is, what applications or infrastructure was being outsourced, whether the subject matter of the outsourcing agreement was core or differentiating to the business, whether the provider had met service levels, whether the arrangement had achieved the expected return, how much time was left on the contract and how much it would cost to get out of the deal. "If you decide to stay with an outsourcer, you would want to see your unit cost go down, since the volume would be going up," Rygwalski says.
Bank of America Corp.'s $47 billion acquisition of Fleet in fall 2003 resulted in an extension of BoA's IT outsourcing agreement with Electronic Data Systems Corp. to cover the Fleet portion of the new entity. That decision has stood the companies in good stead. "Setting up an outsourcing relationship [like BoA's with EDS] is a large, complex task. If the newly acquired company can just be folded in, they can save themselves a year of work," says Rob Finkel a partner in the global technology transactions group of Milbank, Tweed, Hadley & McCloy LLP in New York.
Underlying the financial and contractual evaluations will be matters of culture, which are harder to assess and account for. It is not uncommon for one organization to be outsourcing-averse, such as Bank One, while the other embraces outsourcing (J.P. Morgan Chase). Though traditionally the acquiring company would simply install its own IT infrastructure at the acquiree, that is no longer the case, at least in the banking industry (as seen in J.P. Morgan's canceling of the IBM contract).
"It does not matter who is doing the acquiring and who is being acquired. Both sides will decide who has the better IT, and the new company will adopt that. These days, institutions are savvier about going with whichever IT infrastructure is more effective," Garcia says.
Rygwalski has a new perspective on IT outsourcing in merger situations. At Exigen, Rygwalski has seen organizations formally spin off the outsourced portion of the business (often with the help of a vendor such as Exigen), providing the services back to the new organization but also selling them on the open market.
"Two companies come together. Maybe they're insourced, maybe they're outsourced. You partner with a third party that can bring technology and business process expertise to the table to create a joint venture and then sell it back to the original company as well as others in the same industry. Now you've made this another asset for the company," Rygwalski says.
Since a majority of Fortune 500 companies have outsourced one or more applications, processes or functional areas - and since the big deals that necessitate revisiting those relationships are heating up - this is sure to be an issue more and more CIOs will face this year and beyond. - Lauren Gibbons Paul
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